Question

Explain how inflation and interest rates affect the capital budgeting process?

Answer 1

Answer) Impact of Inflation on capital budgeting:

Prices do not remain constant over a period of time. They tend to change due to various economic, social or political factors. Changes in the price levels cause two types of economic conditions, inflation and deflation. Inflation may be defined as a period of general increase in the prices of factors of production whereas deflation means fall in the general price level. These changes in the price level lead to inaccurate presentation of financial statement and also have a significant impact on investment decisions which can be made clear with: help of the following example:

Fixed assets at cost $ 10,00,000

Less Accumulated Depreciation   $ 4,00,000

Fixed Assets $ 6,00,000

Add Current Assets    $ 8,00,000

$ 14,00,000

Less Current Liabilities $ 5,00,000

Capital Employed $ 9,00,000

Net profit after tax and depreciation is say $ 2, 70,000.The rate of tax is 50% and depreciation is charged at 10% per annum on original cost. The replacement cost of the fixed assets is $25, 00,000.

In the above example, when the fixed assets are maintained at historical cost concept the return on capital employed is 2,70,000X 100 =30%

9,00,000   

However if calculate the return on capital employed, keeping in mind the inflation and the replacement cost of the fixed assets.

Net profit (after tax and depreciation on original cost)			$	2,70,000
Add: Depreciation 10% on original cost			$	1,00,000
Add tax already charged at 50%			$	2,70,000
Profit before depreciation and tax			$	6,40,000
Less Depreciation 10% on replacement cost of 25,00,000			$	2,50,000
			$	3,90,000
Less tax (50%)			$	1,95,000
Net Profit			$	1,95,000
Capital Employed :
Fixed Assets (Replacement Cost)			$	25,00,000
Less Accumulated Depreciation (assumed to be 40%, same on the original cost)			$	10,00,000
			$	15,00,000
Add Current Assets			$	8,00,000
			$	23,00,000
Less Current Liabilities			$	5,00,000
Capital Employed			$	18,00,000
Return on capital employed =	1,95,000	x 100 =	10.83%
	18,00,000

On comparing the return on capital employed as shown as historical cost concept which is 30% we find that it is much higher than return on capital employed based on replacement cost concept. In reality, we have earned only 10.83% on today's capital. In the same may the tax liabilities on the historical cost concept is $ 27,00,000 which is much higher than tax liability of $1,95,000 based in replacement cost concept. Thus accounting based on historical cost concept inflates book profits increase tax liability and erodes equity capital. In the recent past, there have been cases where dividend and taxes have been paid out of the real capital due to the effect or price level changes (inflation) on financial statements. Thus there is every need to adjust the conventional accounting in the light of price level changes or adopt the price level accounting.

An most of the investment decisions are based on the concept of cash flows, there is every need to adjust the money cash flows with purchasing power equivalents to determine the real cash flows or inflation adjusted cash flows. However if there is zero inflation there is no need to distinguish between money and real cash flows as both would be identical. The difference between money cash flows and real cash flows arises when there is inflation.

Impact of interest rates on capital budgeting:

Interest rates primarily influence a corporation's capital structure by affecting the cost of debt capital. Companies finance operations with either debt or equity capital. Equity capital refers to money raised from investors, typically shareholders. Debt capital refers to money that is borrowed from a lender. Common types of debt capital include bank loans, personal loans, credit card debt and bonds.

A certain price must be paid for the privilege of accessing funds when using either debt or equity; this is called the cost of capital. For equity capital, this cost is determined by calculating the rate of return on investment that shareholders expect based on the performance of the wider market and the volatility of the company's stock. The cost of debt capital, on the other hand, is the interest rate lenders charge on the borrowed funds.

Given the choice between a business loan with a 6% interest rate and a credit card that charges 4%, most companies opt for the latter option because the cost of capital is lower, assuming the total amount of borrowed funds is equivalent. However, many lenders advertise low interest products only to divulge that the rate is actually variable at the issuer's discretion. A capital structure including a credit account with a 4% interest rate may need to be significantly revised if the issuer decides to bump the rate to 12%.

One benefit of debt capital is that interest payments are usually tax-deductible. Even if interest rates rise, the cost is partially offset by the reduction in taxable income.

Because payments on debt are required regardless of business revenue, the risk to lenders is much lower than it is to shareholders. Shareholders are only paid dividends if the business turns a profit, so there is a possibility that the investment will fail to generate adequate returns. Due to this decreased risk of default, most debt financing options still carry a lower cost of capital than equity financing unless interest rates are particularly steep.